Sukuk activity enters an uncertain phase

Improving liquidity conditions may help investor demand pick up

Against the backdrop of a slowdown in the global Islamic financial services industry, sukuk activity in the GCC region is facing an uncertain future, according to rating agency Standard & Poor’s.

Sukuk activity witnessed a strong recovery in the first half of 2017 compared with the same period in 2016, thanks primarily to the jumbo issuances of GCC governments, but analysts are less certain about 2018.

“We believe this performance this year stemmed mainly from the good liquidity conditions in the GCC and more generally in the global financial market. Although we expect issuance numbers will stay solid for the rest of 2017, we consider it unlikely that some of the large transactions seen in the first half of the year will be repeated in 2018,” said S&P Global Ratings’ Head of Islamic Finance Dr Mohammad Damak.

Most of the investors in sukuk are in the GCC and banks are major players in this universe.

Over the past two years, a reduction of liquidity in GCC banking systems due to reduced deposit inflows as a result of low oil prices and high dependence on deposits from governments and their related entities impacted investments.

This situation started to reverse in the first half of 2017 after oil prices stabilised and governments issued large bonds and injected liquidity locally.

Sizeable cash assets

GCC banks tend to keep sizable amounts of cash and money market instruments on their balance sheets.

In the currently difficult operating environment, marked by few opportunities for lending growth, analysts expect more banks to invest a portion of their liquidity in assets that generate higher income than cash and money market instruments. In this context, bonds and sukuk appear more attractive than interbank or central bank deposits.

Global liquidity remained abundant in the first half of 2017 and is expected to continue until the year’s end.

The European Central Bank (ECB)’s Quantitative Easing (QE) programme, the slow increase in the Fed’s interest rates, and good liquidity in some Asian countries will continue to support demand for both bonds and sukuk.

The cost of funding might start rising, however, as the Fed increases its rates and the ECB tapers its QE programme.

Given the current low interest rates in developed markets, emerging-market issuers with good credit stories might still be on investors’ radar, as shown by the significant oversubscription of some recent transactions.

S&P Global Ratings’ Head of Islamic Finance

Regulatory improvements

There has been some progress on reducing the complexity of sukuk issuance, but it is not sufficient, according to S&P. It is still more time-consuming and complex to tap the sukuk market than to issue a conventional bond, even though this situation has improved over the years.

Positively, in the first half of 2017, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and other financial industry heavyweights pushing the market toward greater standardisation.

The AAOIFI has issued exposure drafts on central Sharia boards and sukuk accounting that aim to address the complexity related to Sharia compliance and legal structuring of sukuk.

But the process for issuing sukuk is still not as smooth as that for a conventional bond.